Mergers and acquisitions (M&A) between U.S. exploration and production companies continued on a slow pace in the second quarter, and unless oil and gas prices sustain a rise in the final half of the year, the lull could continue, as sellers hold their ground and refuse to drop their prices, said Standard & Poor’s in a new ratings round-up of domestic energy companies.

Companies able to take advantage of opportunities without overleveraging their balance sheets will be well prepared for the market’s recovery. However, those burdened with debt payments and low prices may be taken out of the market altogether, a fate that forced at least three into bankruptcy during the quarter.

Many E&Ps are working to exploit the current market lull by attempting M&As, but only those with manageable debt will actually benefit. Smaller independents Contour Energy Corp, Tri-Union Development Corp. and Abraxas Petroleum Corp “all lacked funds for timely interest payments during the quarter,” forcing them into bankruptcy, according to S&P. While Tri-Union and Abraxas have since made payments through asset sales or bondholder agreements, Houston-based Contour remains in default because of provisions that were enacted by its secured debt holders.

More trouble could be ahead for those highly leveraged, said S&P. “Although the current rebound in hydrocarbon pricing may provide some breathing room to this sector, more permanent solutions are needed to free liquidity from debt-financing costs.” If a sustained recovery in oil and gas prices does not continue in the third and fourth quarters, “look for further negative actions on highly leveraged E&P companies.”

In the energy services sector, S&P found M&A activity higher as companies work to make “opportunistic acquisitions to prepare for the next up-cycle,” something E&Ps cannot necessarily do. “E&P acquisitions will likely lag as long as sellers keep looking for high prices, and hydrocarbon prices, particularly natural gas, fail to strengthen significantly. Nevertheless, a hot summer cooling season coupled with reduced natural gas production and increasing industrial demand in the third and fourth quarters could spark some activity.”

Also, the refining and marketing sector “could also see some M&A activity as the larger players, such as Phillips Petroleum Co., Conoco Inc., El Paso Corp. and The Williams Cos., have announced plans to sell refineries. Nevertheless, activity may be limited as a result of the diminished cash flows due to the dismal margins achieved in the past two quarters,” wrote S&P. “In a low-price environment, ratings changes are likely to be biased toward negative actions given reduced cash flow and greater difficulties accessing capital to meet working capital needs or to refinance maturing debt,” said S&P. “Particularly vulnerable to adverse ratings changes are companies already in distress (which would be rated in the ‘CCC’ category) or those that have low ratings (‘B’ category).”

In assigning ratings to companies in the oil and gas sector, S&P assumes for 2002 that spot West Texas Intermediate oil prices will average $21/bbl and that Nymex natural gas prices will average $2.75/MMBtu, much lower than prices in 2001. “The lower assumptions are based on risks posed by elevated inventories — especially for North American natural gas; slow U.S. economic growth; and the potential for non-OPEC production growth in 2002 to outstrip expected demand.” In 2003, S&P has assumed oil prices of $19/bbl and natural gas prices of $2.75/MMBtu.

“If actual realized prices are near Standard & Poor’s assumptions, the industry will post credit measures during the next two years that are sharply weaker than those recorded in 2001,” said the credit ratings agency. However, if prices this year and next “greatly exceed” assumptions, S&P would review companies with “respect to the magnitude and use of proceeds of these ‘windfall’ profits and cash flow,” it said.

“The potential for outperformance is in place — in mid-June the 12-month Nymex natural gas futures strip was about $3.65/MMBtu and the 12-month Nymex oil strip was about $25.25, thanks in part to a geopolitical risk premium for oil and prospective concerns about a shortfall in natural gas supply in 2003 caused by insufficient reinvestment in production capacity. Nevertheless, Standard & Poor’s remains cautious in the very near term based on the fundamental outlook for each commodity.”

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